empirical tax research in accounting sevlin shackelford2001

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Empirical tax research in accounting


Douglas A.Shackelford


*, Terry Shevlin

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Kenan-Flagler Business School, University of North Carolina, McColl Building, Campus Box 3490, Chapel Hill, NC 27599-3490, USA


School of Business Administration, University of Washington, Seattle, WA 98195-3200, USA

Received 14 October 1999; received in revised form 21 February 2001


This paper traces the development of archival, microeconomic-based, empirical income tax research in accounting over the last 15 years.The paper details three major areas of research: (i) the coordination of tax and non-tax factors, (ii) the effects of taxes on asset prices, and (iii) the taxation of multijurisdictional (international and interstate) commerce.Methodological concerns of particular interest to this field also are discussed.The paper concludes with a discussion of possible directions for future research.r2001 Elsevier Science B.V. All rights reserved.

JEL classification:M41; H25; K34; G32; F23

Keywords:Taxes; Empirical tax research; Non-tax costs; Financial reporting costs; Tax capitalization

1. Introduction

Tax research has long attempted to address three questions of scholarly and policy interest: Do taxes matter? If not, why not? If so, how much? Current tax research in accounting addresses these questions using a framework developed


We appreciate the helpful comments by Jennifer Blouin, Julie Collins, Merle Erickson, Bill Gentry, John Graham, David Guenther, John Hand, Michelle Hanlon, Deen Kemsley, Ed Maydew, Mary Margaret Myers, Jana Smith Raedy, Doug Skinner, Ross Watts, Robert Yetman, Jerry Zimmerman and the research assistance by Courtney Edwards.

*Corresponding author.Tel.: +1-919-962-3197; fax: +1-919-962-0054.

E-mail address:doug shack@unc.edu (D.A. Shackelford).


by Scholes and Wolfson (SW, 1992).1 This paper traces the genesis of the framework and its influence on the development of archival, microeconomic-based, empirical tax research in accounting over the last 15 years.It is intended to serve as a historical record, an introduction for doctoral students and other interested parties, and a guide for identifying important unresolved issues in the literature.

Although tax research has a long history in economics and finance and many accounting practitioners specialize in tax planning and compliance, accounting academe was slow to adopt taxes as an important area of inquiry.Besides empirical inventory costing studies (e.g., Ball, 1972; Dopuch and Ronen, 1973; Sunder, 1973, 1975), tax research by accountants before the mid-1980s could be dichotomized into two lines: (a) legal research, evaluating the effects of taxes on exogenous transactions, usually published in law journals, and (b) policy studies, evaluating the distributional or efficiency effects of taxes, usually published in public economics journals.Few tax papers were published in general interest accounting journals.Although seminal studies in corporate finance, many of which examined tax issues (e.g., Modigliani and Miller, 1963), influenced financial accounting research, they did not similarly affect tax research in accounting.

By the mid-1980s, finance was losing interest in tax research.Myers (1984, p. 588) expressed finance’s frustration with empirical tax studies in his presidential address, ‘‘I know of no study clearly demonstrating that a firm’s tax status has predictable, material effects on its debt policy.I think the wait for such a study will be protracted.’’ Scholes, a finance professor, and Wolfson, an accounting professor, responded by adopting a microeconomic perspective to analyze settings where taxes were likely important.

The Scholes–Wolfson paradigm does not advance new theories or methodology.It focuses on neither detailed legal aspects nor policy recommendations.Rather it adopts a positive approach in an attempt to explain the role of taxes in organizations.Drawing extensively from corporate finance and public economics, it merges two distinct bodies of knowledge: microeconomics and tax law.The paradigm is central to current empirical tax research in accounting, important in public economics, and somewhat influential in corporate finance.

Its conceptual framework is developed around three central themes (known as all parties, all taxes, and all costs), none of which is particularly novel or counterintuitive:

* ‘‘Effective tax planning requires the [tax] planner to consider the tax

implications of a proposed transaction for all of the parties to the transaction.


* Effective tax planning requires the planner, in making investment and

financing decisions, to consider not only explicit taxes (tax dollars paid directly to taxing authorities) but also implicit taxes (taxes that are paid indirectly in the form of lower before-tax rates of return on tax-favored investments).

* Effective tax planning requires the planner to recognize that taxes represent

only one among many business costs, and all costs must be considered in the planning process: to be implemented, some proposed tax plans may require exceedingly costly restructuring of the business.’’ (SW, p. 2).

An example of all parties is considering both employer and employee taxes when structuring compensation.An example of all taxes is a municipal bond, which carries a lower interest rate because its interest is tax-exempt.An example of all costs is the tradeoff between corporate financial accounting and tax objectives.

The three themesFall parties, all taxes, and all costsFprovide a structure for tax management that achieves organizational goals, such as profit or wealth maximization.The themes imply that tax minimization is not necessarily the objective of effective tax planning.Instead, effective tax planning must be evaluated in the efficient design of organizations and through adoption of a contractual perspective.The paradigm implicitly assumes that if all contractual parties, all taxes (explicit and implicit), and all non-tax costs can be identified and controlled, then the observed tax behavior will be rational and predictable. Typically, the quality of research in this area is evaluated based on whether the research design identifies and controls for all parties, all taxes, and all costs. The paradigm is so widely accepted in accounting that differences between predicted and actual are attributed to unspecified exclusion of an important party, tax, or non-tax cost.Contrary evidence is presumed to reflect model misspecification or measurement error.No paper challenges the validity of the SW framework.


Despite its shortcomings, the framework accounts for the recent surge in tax research in accounting.2Tax now rivals managerial accounting and auditing for second billing in the research community after financial accounting.The most active researchers in this area are well-trained empiricists with an understanding of tax law.Newly minted accounting doctoral students who combine professional tax experience with an understanding of microeconomics and finance are ideally situated to adopt the new tax perspective.An appreciation of the nuances of the tax law stands as a substantial barrier to entry for many accounting researchers, particularly in the more technically challenging areas, such as international tax and mergers and acquisitions.

Most of the research is best described as documentation.In the early years of the framework, the demand for documentation was clear.For example, Scholes and Wolfson (1987) state, ‘‘What is most lacking in the literature at the moment is a documentation of the facts.’’ The literature is slowly shifting from documentation to explanation, understanding, and prediction, an evolution that is critical to the field’s advancement.

Quasi-experimental opportunities (e.g., changes in the tax law) and data availability have directed tax research more than hypothesis testing of competing theories.In particular, the development of the framework coincided with passage of the Tax Reform Act of 1986 (TRA 86), which overhauled the US tax system.Many tax studies applied the framework to examine the economic effects of TRA 86 (e.g., Collins and Shackelford (1992), Matsunaga et al.(1992), and Scholes et al.(1992) among many others).

At first, the empirical tax papers built on SW alone.Instead of a trunk with major branches, the tax literature grew like a wild bush, springing in many directions from the SW root.In recent years, at least three major areas of inquiry (tax and non-tax tradeoffs, taxes and asset prices, and multijurisdic-tional) have emerged.This review evaluates these three areas of greatest development in the hope that understanding the progress in these areas may provide insights into the factors that promote the production of empirical tax research in accounting.For example, current working papers in international tax reflect a much higher quality than the studies that were published in the early 1990s.The advances are attributable to improvements in theory, data, and research design.Similar improvements are evident in research evaluating the coordination of taxes and financial reporting considerations and in recent studies of implicit taxes (also known as tax capitalization) that attempt to quantify the effect of taxes on asset prices.

2To calibrate the framework’s influence and recency, we reviewed theJournal of Accountin

gand Economics,Journal of AccountingResearch, andThe AccountingReviewfor papers that include the


Our challenge in this paper is to delineate tax research in accounting from tax research in other fields and from other types of accounting research.The multidisciplinary nature of taxes means that tax accountants often conduct microeconomics-based empirical research with non-accounting tax researchers (e.g., Scholes and Wolfson’s joint work) and with non-tax accounting researchers, particularly financial accountants.It is also not unusual for the work to be published in economics journals (e.g.,Journal of Public Economics

and National Tax Journal) and leading finance journals.Thus, defining tax

research in accounting becomes imprecise at best.

To the extent possible, we have attempted to address this issue by concentrating on areas where accountants have made the greatest contribution to academe’s understanding of taxes.For example, accountants have concentrated almost solely on income tax research.This focus likely reflects both the centrality of income measurement in the field of accounting and the historical emphasis on income tax consulting by tax accountants.However, the lines are blurring as tax accountants increasingly contribute to the broader academic field of taxes.By importing mainstream accounting research concerns (e.g., the role of earnings) into tax analyses, where accounting topics traditionally have been ignored, tax accountants are tilting tax inquiries toward longstanding accounting issues.In short, the body of knowledge produced in recent years by tax accountants has influenced both accounting research, infusing it with a tax perspective, and tax research, infusing it with an accounting perspective.

Finally, besides the usual scholarly demand for understanding, the demand for microeconomics-based tax research in accounting is fueled partly by the popularity of the research in the classroom.An indication of the research-teaching link is the fact that the seminal work in the field (SW) is an MBA textbook.In the SW preface, Scholes and Wolfson attribute the framework to a frustration with the existing tax teaching materials.Later through funding by the Ernst and Young Foundation, their course was taught to several hundred accounting (mostly tax) faculty in the late 1980s and early 1990s.Variants of the tax class are among the most popular MBA electives at many business schools.This unusually strong synergy between teaching and research in the tax area creates a demand for research that can be easily transformed into pedagogical materials (e.g., case studies).

The next three sections concentrate on three major areas of tax research in accounting.Section 2 discusses studies that address the coordination of tax and non-tax factors.Section 3 details research linking asset prices and taxes. Section 4 reviews investigations of the taxation of multijurisdictional (international and interstate) commerce.


detailed criticisms of each individual paper in Sections 2–4, Section 5 discusses six general methodological concerns that are particularly applicable to tax research in accounting.Closing remarks follow.

2. Tax and non-tax tradeoffs

The largest body of tax research in accounting examines the coordination of taxes and other factors in business decisions.The tension surrounding these papers is that taxes cannot be minimized without affecting other organizational goals.Although these studies address each of the three questions of tax research (Do taxes matter? If not, why not? If so, how much?), they focus mostly on the second question, explaining why tax minimization might not be the optimal business strategy.Of the three themes of the framework (all parties, all taxes, and all costs), these papers rely heavily on ‘‘all costs’’, i.e., understanding taxes requires understanding non-tax factors.Some papers reflect ‘‘all parties’’, i.e., a multilateral contracting perspective, but the ‘‘all taxes’’ theme is generally ignored in these studies.

This review of the tradeoff literature is dichotomized into papers that address the interaction of financial reporting and tax factors and papers that examine the effects of agency costs on tax minimization.The papers cover a wide range of settings including inventory, compensation, and tax shelters.Although it is difficult to summarize a large literature, common themes in these papers are:

* taxes are not a cost that taxpayers inevitably avoid;

* tax management is complex and involves many dimensions of business;

* the effects of financial reporting considerations on taxes is better understood

than the effects of agency costs;

* quantification of non-tax costs has progressed slowly.

2.1. Financial reportingconsiderations


lower taxable income against the financial reporting incentives to increase book income.

Although tax accounting and financial accounting often differ in revenue recognition and other important concerns, tax plans often result in reporting lower book income.Thus, it is not surprising that tax planning affects financial accounting choices and that financial accounting considerations affect tax plans.In fact, tax accountants have contributed to the multidisciplinary field of taxes by demonstrating the extent to which financial reporting considerations affect tax choices.Likewise, tax researchers have contributed to accounting research by demonstrating that tax considerations often affect accounting choices.

The remainder of this section reviews several research settings used to calibrate book and tax tradeoffs in an attempt to answer the question, ‘‘What is known about the relation between financial accounting considerations and tax considerations?’’ In short, the literature suggests that financial accounting management and tax management are not independent and neither considera-tion consistently dominates the other in decision-making.A key implicaconsidera-tion from these studies is that financial accounting considerations may be an important omitted correlated variable in tax studies, and tax considerations may be an important omitted correlated variable in financial accounting studies.

Finally, as detailed in Section 5, empirical tax researchers face a number of methodological issues.We briefly overview some of them here to set up our discussion of individual papers.

Empirical tax researchers examining corporate behavior generally require an estimate of a firm’s marginal tax rate.Unless otherwise explicitly noted, the studies discussed below proxy firms’ tax status with a dummy variable equal to 1 if the firm has a net operating loss carryforward (NOL) and 0 otherwise.We argue in Section 5 that this variable measures a firm’s marginal tax rate with error and thus caution must be exercised in interpreting results based on the NOL dummy variable.We discuss an alternative approach based on repeated simulations of firms’ future taxable income (Shevlin, 1990; Graham, 1996a, b).


2.1.1. Inventory accounting

Research addressing the tension between tax and book incentives can be traced to numerous studies evaluating the LIFO conformity requirement in the 1970s before SW.This literature grew out of interest in two questions.First, do stock prices change in an efficient or unsophisticated manner at releases of information about LIFO adoptions? If managers are sophisticated, then an LIFO adopter would experience declines in both reported earnings and the present value of corporate taxes (Ball, 1972; Sunder, 1973, 1975; Ricks, 1986). In such a setting, it was argued that a functional fixation view of investors would predict that LIFO adopters would experience negative stock price changes when the lower LIFO-based earnings were announced.In contrast, an efficient market view of investors predicts they would disregard the lower book earnings and value the LIFO tax benefits so that LIFO adopters would experience positive stock price changes at adoption announcements.

On balance, the empirical results of investigations into LIFO adoption announcements during the 1970s and 1980s were inconclusive and puzzling. Researchers found little evidence of a positive mean excess stock return at the initial disclosure of actual or potential LIFO adoptions.Lanen and Thompson (1988) model the stock price reaction to a voluntary accounting change, such as LIFO adoption.They show that if investors rationally anticipate voluntary accounting changes, then the sign of the association between the stock price reaction at the announcement date and firm-specific characteristics (measuring the expected cash flow effects of the change) are difficult to predict.Later Kang (1993) argued that LIFO adoptions should be accompanied by negative stock returns because the decision to adopt LIFO is rational if a firm on FIFO sees unexpectedly higher future inflation for its input prices.In other words, the adoption of LIFO signals optimizing in the face of unexpectedly bad news about long-term input price inflation.Hand (1993) tested Kang’s theory using firms that announced they were considering adopting LIFO and then resolved that uncertainty by either adopting LIFO or remaining on FIFO.Hand’s results, after including controls for Lanen and Thompson’s arguments on prior probability of adoption, were broadly consistent with the major predictions of the Kang model.In particular, firms that resolved the LIFO adoption uncertainty by adopting LIFO (remaining on FIFO) experienced reliably negative (positive) mean excess returns at the resolution of uncertainty date. Thus, Kang and Hand appear to have provided a reasonable explanation for the earlier empirical findings of a negative stock price reaction to the announcement of LIFO adoption.


and LeClere, 1992).After reviewing the literature, Jenkins and Pincus (1998) conclude that tax savings dominate earnings management concerns when firms adopt LIFO.

Several papers have examined the role of tax and non-tax factors in inventory management by LIFO firms.Firms can increase reported earnings by liquidating LIFO layers but at a tax cost because taxable income also increases.Firms can decrease reported earnings and taxes by addi-tional year-end purchases at higher prices.3 Dhaliwal, Frankel, and Trezevant (DFT, 1994) find that both tax and financial reporting factors affect LIFO liquidations.Liquidations are larger and more common for low-tax firms (measured as the existence of an NOL carry-forward) and more likely to occur when earnings changes are negative and firms have greater leverage.Also measuring taxes by the existence of an NOL carryforward, Frankel and Trezevant (1994) find that taxes affect LIFO firms’ year-end purchasing behavior, but financial reporting considerations do not.

Hunt, Moyer, and Shevlin (HMS, 1996) do not find that taxes affect inventory decisions of LIFO firms.Recognizing inventory management as one of many options LIFO firms can employ to manage taxes and earnings, they incorporate LIFO inventory management together with current and non-current accruals in a cost minimization model (based on a model developed by Beatty et al., 1995b). Although HMS’s financial reporting results concur with DFT, their tax results do not.Sensitivity tests attribute the difference to HMS’s using a system of equations and employing a more sophisticated measure of a firm’s tax status.

Using a system of equations allows for simultaneity among the three choice variables HMS study but requires the researcher to make assumptions about which exogenous variables to include in each model.It is necessary to have at least one different exogenous variable in each regression model to identify (estimate) the system.These choices are sometimes somewhat arbitrary and results in simultaneous equations can be sensitive to which variables are included and excluded in each regression.

HMS use the simulation approach to estimate each firm’s marginal tax rate.We believe that while the simulation approach is not without its own problems, it provides a superior measure of firms’ marginal tax rates.Thus, when results differ between studies using an NOL dummy variable and the simulation estimate, we attach more credence to the simulation-based results.


The final LIFO choice facing a firm is LIFO abandonment.Johnson and Dhaliwal (1988) examine the tradeoff between taxes and financial statement effects in the LIFO abandonment decision.Consistent with abandonment increasing taxes and lowering financial reporting costs, they find abandonment firms are more leveraged, closer to violating working capital covenants, and have larger NOL carryforwards.Additional tests regress the disclosed tax costs of abandonment ($7.8 million on average) on financial statement variables. These tests are particularly intriguing because they use actual firm estimates of the tax costs to test the tradeoffs between tax and other factors.After analyzing 22 firms closely, Sweeney (1994) finds that despite financial reporting benefits, firms will not switch to FIFO if the change generates ‘‘significant’’ tax costs.4 Overall, we conclude that taxes are an important determinant (have a first-order effect) in firms’ decisions to adopt LIFO, in LIFO liquidations, and in LIFO abandonment.However, we believe that the evidence in HMS Hunt et al. (1996) suggests that taxes are far less important than financial reporting considerations for firms wishing to manage earnings through LIFO inventory management.

2.1.2. Compensation

Compensation is another business cost affected by both tax and financial reporting incentives.Several papers have examined the role of taxes in the choice between firms issuing incentive (or qualified, ISOs) and non-qualified employee stock options (NQOs).On an aggregate usage level, the relative use of ISOs and NQOs has changed over time, consistent with changes in the tax laws favoring one or the other option type.For example, Hite and Long (1982) report that firms switched from ISOs to NQOs after the top individual tax rates were lowered in the Tax Act of 1969 (making ISOs less tax favored relative to NQOs).Similarly, the Tax Reform Act of 1986 reduced the attractiveness of ISOs considerably because not only was the top individual rate set below the top corporate rate but the capital gains rate was set equal to the tax rate on



ordinary income.5Balsam et al.(1997) document that NQO usage increased relative to ISOs after 1986.However, papers that examine firm-specific usage of ISOs and NQOs as a function of corporate and individual tax rates fail to find results consistent with their tax predictions.For example, Madeo and Omer (1994) report that firms that switched from ISOs to NQOs following the 1969 Tax Act tended to be firms with low tax rates, when from a purely tax viewpoint, the high-tax firms should be the ones switching.Austin et al.(1998) report that the firm’s marginal tax rate (estimated using the simulation approach) appears to have played little role in the choice of option type during the 1981–1984 period, with the choice appearing to be driven by minimizing the executives’ tax burden.Thus the extant evidence is somewhat mixed on the role of taxes in the choice between ISOs and NQOs and, if we were forced to make a judgment on the current state of knowledge, we would interpret the evidence as consistent with taxes not being an important determinant of individual firm’s choice between ISOs and NQOs.

Using the framework’s ‘‘all parties’’ approach, Matsunaga, Shevlin, and Shores (MSS, 1992) examine a setting where employers tradeoff the tax benefits of a corporate deduction for compensation with the financial reporting costs of lower earnings arising from transaction costs.Specifically, they investigate the response to TRA 86’s tax rate changes that reduced the tax advantages of ISOs relative to NQOs.

One possible response for employees holding ISOs is to exercise them and sell the stock within 12 months of exercise, resulting in a disqualifying disposition.A disqualifying disposition automatically converts ISOs into NQOs.Disqualification generates ordinary taxable income for the individual and transaction costs for both employee and employer, with the transaction costs to the employer reducing book earnings.6The negatives must be balanced against the tax savings of a compensation deduction for the firm.

MSS analyze the tradeoffs by holding employees indifferent and computing the net tax benefits for employers (using the simulation approach to estimate each firm’s marginal tax rate).Consistent with firms coordinating taxes and financial reporting, MSS find that disqualification is more common among firms facing fewer financial reporting constraints.They estimate that firms without disqualifications avoided roughly a 2.3 percent reduction in reported earnings, on average, at a mean cost of net tax benefits of $0.6 million. Because of data limitations MSS are required to make assumptions (discussed explicitly

5TRA 86 lowered the maximum statutory corporate tax rate from 46 to 34 percent and the maximum statutory personal tax rate from 50 to 28 percent while increasing the maximum statutory personal long-term capital gains tax rate from 20 to 28 percent.


in their paper) to estimate both the tax benefits and financial reporting consequences of a disqualifying disposition, which unavoidably bias them toward finding in favor of the alternative hypothesis.For firms that did not disqualify, as-if numbers are required.This creates a problem common to many studies, both tax and non-tax (for example, pre-managed earnings in earnings management studies), and the results.The inferences must be interpreted cautiously in the light of the assumptions underlying the as-if calculations.

Pensions are another form of compensation that has attracted book–tax analysis.Pension contributions reduce taxable income while pension expense reduces book income.Francis and Reiter (1987) test whether the level of pension funding varies with tax incentives to overfund and financial reporting incentives to underfund.They find funding levels are increasing in marginal tax rates and decreasing in financial reporting costs (measured by leverage). Examining similar issues, Thomas (1988) focuses on taxes while controlling for financial reporting effects via sample selection and inclusion of profitability and leverage variables.His results are generally consistent with Francis and Reiter (1987).

Thomas (1989) and Clinch and Shibano (1996) explore whether taxes motivate termination of overfunded defined benefit pension plans.Thomas concludes that firms seem more motivated by cash needs than by taxes (measured by an NOL carryforward variable) whereas Clinch and Shibano, using a more sophisticated approach to estimating expected tax benefits, report results consistent with taxes playing an important role in the decision and timing of pension plan terminations.7 Both studies indicate that financial reporting considerations are a second-order motivation for plan terminations. Mittelstaedt (1989) also ignores financial reporting issues in examining pension asset reversions (either through reduced contributions or plan terminations). The results of the papers that omit financial reporting considerations must be interpreted with caution because of concerns with correlated omitted variables. Nevertheless, the evidence is consistent with taxes being an important determinant of firm’s funding policy and also of pension termination decisions when more sophisticated techniques are used to estimate tax effects of the termination.

Finally, deferred compensation would appear to be a particularly useful setting for investigating both tradeoffs and agency costs.However, to date, no empirical evidence has applied the SW framework to document the tax and non-tax factors that determine deferred compensation.We look forward to such an analysis.


2.1.3. Intertemporal income shifting

Passed in 1986, TRA 86 phased-in tax rate reductions through 1988 (e.g., for calendar year companies the maximum regular tax rate fell from 46 percent in 1986 to 40 percent in 1987 and 34 percent in 1988).This precommitment to lower rates enabled tax managers to plan, knowing that rates were falling.This provided a powerful setting to assess firms’ willingness to obtain tax savings by deferring earnings.Scholes et al.(1992) report that larger companies are more active income shifters.They acknowledge that financial reporting considera-tions likely impede shifting income into future periods, but their research design does not include any measures designed to capture these incentives.

Guenther (1994a) extends Scholes et al.(1992) to include proxies for financial reporting costs.He confirms that large firms shift more but adds that firms with higher leverage ratios (a proxy for financial reporting costs) are less willing to report lower income.Thus, shifting income to save taxes appears coordinated with managing debt covenant violation costs.Lopez et al.(1998) extend Guenther (1994a) to report that income shifting is concentrated among firms that exhibited prior tax aggressiveness (as measured using the tax subsidy measure from Wilkie and Limberg, 1993).

The rate reductions in TRA 86 also provided an incentive to maximize NOL carrybacks to years before rates fell (e.g., 1986). Maydew (1997) tests for NOL-induced income shifting using leverage to measure financial reporting costs.He estimates firms with NOL incentives to carryback losses shifted $2.6 billion less operating income because of costs associated with increasing leverage.This compares with total shifting of $27.2 billion of income, showing the restraints from financial reporting considerations were substantial.

While its rate reduction was providing incentives to shift income from 1986 to later years, TRA 86’s alternative minimum tax provided incentives to shift book income back to 1986 or forward, beyond 1989.From 1987 to 1989, book income was a component of taxable income for firms subject to the AMT.This direct link between book and tax provided an unusually powerful setting for calibrating the exchange rate between book earnings and taxable income.

Several studies estimate the AMT impact on reported earnings.Gramlich (1991) finds the AMT exerted downward pressure on firm earnings.He adds that firms shifted book earnings from 1987 to 1986 to avoid taxes.Using actual tax returns to identify AMT firms, Boynton et al.(1992) confirm income shifting.However, their study omits controls for financial reporting incentives. Dhaliwal and Wang (1992), Manzon (1992), and Wang (1994) concur with Gramlich (1991) that firms shifted income from 1987 to 1986.


(firms report they paid the AMT).Both approaches are problematic, as discussed by Choi et al.(1998).Further, the treatment firms are compared with control firms that have alternative income shifting incentives because of the contemporaneous change in corporate statutory tax rates.Finally, as recognized by Manzon (1992) the treatment firms vary in their incentives because the effective AMT tax rate varies cross-sectionally.Thus, Choi et al. (1998) contend on methodological grounds that little evidence supports AMT-driven income shifting and we concur with their contention.Finally, to our knowledge, no study jointly evaluates the rate reduction incentives to realize income after 1986 and the AMT incentives to realize income in 1986.

2.1.4. Capital structure, divestitures, and asset sales

Engel, Erickson, and Maydew (EEM, 1999) analyze an unusual security, trust preferred stock (TRUPS), from the perspective of tax and financial reporting tradeoffs.GAAP does not treat TRUPS as debt even though their dividends are deductible.Thus, firms that retire outstanding debt with the proceeds from TRUPS strengthen the appearance of their balance sheet.8EEM find that for the 44 issuers that used TRUPS to retire debt, the debt/asset ratio declined on average by 12.8 percent. EEM estimate upper and lower bounds of the costs to the firm of reducing the debt/asset ratio.The lower bound is the average actual issuance costs of the TRUPS across issuers, estimated at $10 million.The upper bound is estimated using the 15 TRUPS issuers that retired debt, rather than their outstanding traditional preferred stock.By not retiring the traditional preferred stock, the issuers chose to forgo tax benefits of $43 million, on average.Thus, firms were willing to pay between $10 and $43 million to improve their balance sheet (i.e., reduce their debt/assets ratio by 12.8 percent).

We find EEM’s quantification of non-tax costs useful and encourage other researchers to attempt such estimations.By estimating the lower and upper bounds of what firms are willing to pay for favorable balance sheet treatment, EEM provides a model for estimating elusive non-tax costs.They demonstrate how taxes can provide a metric for the less quantifiable components in the efficient design of organizations.However, EEM did not model either the issuance choice or the choice of how the proceeds were used (these choices were taken as exogenous), and so their results could suffer from self-selection bias (a correlated omitted variables bias), discussed in more detail in Section 5. Nevertheless, we look forward to more papers that adopt their quantitative approach.

Maydew, Schipper, and Vincent (MSV, 1999) investigate book–tax tradeoffs by examining tax-disadvantaged divestitures, i.e., taxable sales that could have


been avoided with a tax-free spin-off.They conclude that financial reporting incentives and cash constraints lead firms to forego a tax-free spin-off and opt for taxable asset sales.Similar to MSS (1992), in modeling the choice of divestiture, MSV must make assumptions about the effect on the firm if the alternative choice were made in order to calculate as-if calculations.MSV provide a good discussion of the issues (pp.130–132) and recognize this problem leads to inference problems about what variables are driving the choice.In a related study, Alford and Berger (1998) find that spin-offs are more likely when the taxes associated with a sale are large; however, financial reporting considerations mitigate the importance of taxes in the divestiture decision.

Finally, Bartov (1993) finds both earnings (smoothing and debt covenants) and tax incentives influence the timing of asset sales.Klassen (1997) adds that manager-owned firms are more likely to realize losses.He concludes that management ownership reduces financial reporting costs, enabling the firm to place a higher priority on tax management.

2.1.5. Regulated industries

In recent years, the most active setting for evaluating book–tax tradeoffs has been banks and insurers.Regulated industries are particularly useful settings for book–tax comparisons because their mandated disclosures are more extensive than other firms are, and their production functions are relatively simple.Scholes, Wilson, and Wolfson (SWW, 1990) developed the model for research in this area when they analyzed bank investment portfolio manage-ment in regressions that pitted tax considerations against earnings considera-tions and another non-tax factor, regulatory capital.In the SWW setting, a bank can reduce taxable income by selling a security at a loss.9Unfortunately, a realized loss for tax purposes also reduces net income and regulatory capital. Conversely, selling an appreciated security relaxes book and regulatory pressures, but increases taxes.

Collins, Shackelford, and Wahlen (CSW, 1995b) and Beatty, Chamberlain, and Magliolo (BCM, 1995b) extend SWW to recognize that portfolio management is only one means of managing taxes, earnings, and regulatory capital.CSW note that a fully specified model would capture heterogeneity across banks, non-stationarity in tax, earnings and regulatory pressures, endogeneity among bank choices, and autocorrelation within a choice (i.e., exercising a response option now affects its future usefulness).Unfortunately,


capturing all these dimensions in a single estimation is impossible.Thus, the researcher must choose among the dimensions.

CSW relax SWW’s assumption that banks are homogeneous.They estimate bank-specific regressions, capturing bank-specific targets for each objective, rather than cross-sectional pooled means.They examine seven choice variables: security gains and losses, loan loss provisions, loan charges, and the issuance of capital notes, common stock, preferred stock, and dividends.

BCM relax SWW’s assumption of independence among bank decisions. They develop and solve a cost minimization model that leads to a system of equations that they subsequently estimate, subjecting themselves to the same critique of the simultaneous equations approach as HMS (1996).BCM examine loan loss provisions, loan charge-offs, pension settlement transactions, issuances of new securities, and gains and losses from sales of both securities and physical assets.

The different approaches employed by SWW, CSW, and BCM provide triangulation.All three studies find evidence that financial reporting and regulatory considerations affect bank decisions.SWW alone find taxes are an important consideration.10

CSW and BCM’s failures to detect substantial tax effects motivated at least one additional study.Collins, Geisler, and Shackelford (CGS, 1997a) speculate that because all banks face the same US tax rates, banking studies suffer from insufficient power to detect tax effects and so repeat the banking analysis in a setting with more cross-firm tax variation, the life insurance industry.As in banking, conditional on taxable income, all stock life insurers face constant marginal tax rates.However, conditional on taxable income, mutual life insurers face varying marginal tax rates because of an unusual equity tax imposed on mutuals.In this more powerful setting, CGS report that taxes (as well as financial reporting costs and regulatory considerations) affect investment portfolio management.

Beatty and Harris (1999) examining banks, and Mikhail (1999) examining life insurers, extend this literature to investigate whether the relative importance of taxes, earnings, and regulation differs for public and private companies.Both studies report that taxes influence the decisions of private firms more than the decisions of public firms.Since private and public firms face the same tax system, these findings imply that private firms find financial accounting considerations are less important, and consequently, find optimal tax strategies are less costly.

Mikhail (1999) notes that public and private firms differ for at least two reasons: (i) public firms’ compensation schemes are designed to mitigate agency


costs and (ii) public firms are concerned about the stock market interpretations of reduced earnings associated with tax planning.To differentiate between these two explanations, Mikhail examines mutual life insurers.Mutuals have diffuse ownership and concurrent agency costs similar to public firms. However, unlike public firms, mutuals do not face stock market pressure. Mikhail finds that mutual insurers do not manage taxes.Because mutuals’ failure to manage taxes resembles public firms’ actions, Mikhail concludes that public firms’ incentive compensation contracts account for their difference from private companies, rather than stock market pressures.

The veracity of Mikhail’s conclusion depends critically on the assumption that mutual firms face the same set of agency problems as public firms. Furthermore, while Mikhail uses a simultaneous equations approach to examine the multiple choices available to insurers to manage earnings and taxes, he does not model the initial choice of organizational choice and thus faces self-selection bias of unknown severity.Nevertheless, this paper is a good first attempt at probing deeper into the differences between private and public firms’ tax aggressiveness.We look forward to more research that attempts to differentiate between these competing explanations for observed differences between private and public firms.

Finally, the SWW structure has been used to compare taxes and regulatory capital when there are no earnings implications.Adiel (1996) reports that regulatory capital considerations dominate tax concerns in the decision by property-casualty insurers to reinsure.Petroni and Shackelford (1995) find that both tax and regulatory concerns affect the organizational structure through which property-casualty insurers expand operations across states.

Overall, except for the early study of banks by SWW (1990), the evidence from studies of public firms in regulated industries suggests that regulatory capital and financial reporting concerns dominate taxes (although assessment of cross-sectional variation in tax status has been generally limited to the existence of an NOL carryforward).Further, private firms appear to be more aggressive tax planners (either because they do not face capital market pressures or because they face fewer agency problems).

2.1.6. Other settings


This result compliments Keating and Zimmerman (1999).Examining years before tax depreciation was determined by statute, the evidence is consistent with the determination of depreciation for financial accounting being an important factor in justifying tax depreciation deductions to Internal Revenue Service (IRS) auditors.In other words, financial accounting used to affect tax depreciation, but no longer does.

Cloyd et al.(1996) also examine the influence of tax reporting on financial reporting choices.They hypothesize and report evidence (collected by survey) consistent with the idea that management’s choice to conform the tax and financial accounting choice (even though the financial account-ing choice reduces reported book income) is positively associated with the expected tax savings.They also find that public firms are less likely to conform than private firms, consistent with other studies discussed in this review that public firms exhibit less aggressive tax behavior because they face higher non-tax costs arising from capital market pressure or agency costs.

Guenther et al.(1997) provide another example of tax policy affecting financial reports.TRA 86 mandates that firms use the accrual basis.Before TRA 86, firms could use either cash basis (except for inventory) or accrual basis to calculate taxable income.Examining 66 cash method firms, Guenther et al.(1997) find that before the mandated change, cash-basis corporate taxpayers exhibited little tradeoff in their tax planning and financial reporting.However, after the mandated change, the former cash-basis firms deferred income for financial statement purposes.That is, book–tax conformity led the firms to change their accrual behavior.By deferring income, they reduced their taxable income and saved taxes, albeit at the cost of lower reported earnings.

Finally, Mills (1998) tests whether the level of book income affects IRS audits.Using confidential tax return data from the Coordinated Examination Program from 1982 to 1992, she finds that proposed IRS tax adjustments are increasing in the amount that book income exceeds taxable income and that public firms are less aggressive in tax planning, which she attributes to their facing higher financial reporting costs.In our opinion, the most important implication from her results is that firms cannot costlessly reduce taxable income even if book income is not affected.


2.2. Agency costs

Evaluations of tax and non-tax factors extend beyond the financial reporting and regulatory considerations discussed in the previous section.SW (1992, Chapter 7) asserts that agency costs are another non-tax cost responsible for tax minimization not equating to effective tax planning.This section reviews papers that evaluate the effects of adverse selection and moral hazard on tax planning.

Research addressing taxes and agency costs is much less well developed than the book–tax coordination literature.Because incentive problems pervade business, agency problems likely impact tax decisions.Unfortu-nately, the literature has largely been unable to progress beyond identi-fying possible areas where incentives affect tax management.We attribute the paucity of papers in this area to difficulties in quantifying incentive costs.We look forward to both theoretical and empirical advances in this area.

2.2.1. Compensation

Johnson, Nabar, and Porter (JNP, 1999) investigate firm responses to 1993 legislation that disallows a deduction for non-performance-related compensation in excess of $1 million.Affected firms can preserve full deductibility for their five most heavily compensated employees by either qualifying the compensation as performance-based or deferring the compensation until a deduction can be taken.Analyzing 297 publicly held US firms with non-qualified compensation in excess of $1 million in 1992, they find that 54 percent preserve deductibility, most (78 percent) through plan qualification. JNP find that preservation increases in tax benefits (i.e., the product of the excess compensation and the firm’s marginal tax rate) and stakeholder concern about the firm’s compensation plan and decreases in contracting costs.Examining the same legislation, Balsam and Ryan (1996) confirm that agency costs affected the preservation decision.While we commend these researchers for attempting to develop proxies for agency problems, we also note that the proxies are open to arguments and interpretation and thus the conclusions based on these proxies are subject to alternative interpretations.


2.2.2. Tax shelters

Another setting where agency costs have been identified is tax shelters. Although shelters encompass various tax plans, historically they were distinguished by the deductibility of an investment at a rate that exceeds its economic depreciation (SW, 1992, p.393).Shelters create tax savings by repackaging ownership rights among investors.Unfortunately, repackaging can lead to inefficient organizations fraught with incentive problems.

For instance, before TRA 86 severely restricted their usefulness for tax avoidance, limited partnerships (LPs) enabled tax shelters to transfer deductions to limited partners facing high tax rates.Despite their tax effectiveness, these partnerships faced large transaction costs (e.g., sales commissions and investment banking fees commonly absorbed 10 percent of investments) and numerous incentive problems.For example, Wolfson (1985) details several agency costs, including resource allocation among related parties, proving up (i.e., general partner extracting private information using limited partners’ investments), payout allocation and measurement difficulties, overcompletion, and undercompletion.

Space constraints prevent a detailed discussion of each incentive problem. We choose to illustrate one problem, undercompletion.Analyzing the oil and gas tax shelter industry in the 1970s, Wolfson shows that the tax-minimizing drilling structure encouraged undercompletion.From a tax perspective, the value of an LP interest is maximized if the limited partners fund the initial drilling operations, which can be immediately deducted.If the drilling succeeds, the general partner completes the extraction process, which cannot be immediately deducted.If not, the well is abandoned.The undercompletion problem arises because the general partner alone knows the status of the drilled hole.Because the general partner is responsible for all completion costs, but only receives part of the revenues, he will abandon the well unless it is profitable from his perspective, not the partnership’s perspective.For example, if the general partner finds $2 of oil after drilling and knows that it will cost $1 to complete the well, he will only complete the well if he receives more than half the revenues.

Undercompletion occurs because the tax system encourages the limited partner to invest before the general partner.Wolfson provides empirical evidence that undercompletion is mitigated by drilling wells that have a low probability of being marginal (i.e., an exploratory well, where either no oil or excessive oil is expected) and by the general partner’s reputational effects. Wolfson’s empirical evidence is consistent with both tax shelter organizers and the investing public impounding these incentive problems in market prices.


can utilize the immediate deductions from R&D to reduce taxes more than lower marginal tax rate entities and subsequently realize appreciation at tax-favored long-term capital gains tax rates.In addition, in-house R&D uses traditional debt and equity funding while an R&D LP provides an opportunity for ‘‘off-balance-sheet’’ financing.Thus, unlike most studies, where taxes are competing with financial reporting, Shevlin examines a setting where tax and book incentives are aligned.Relying on the empirical agency literature to identify measures of financial reporting costs, Shevlin concludes that both taxes and off-balance sheet financing motivate R&D LPs.One limitation of this study is that in conducting his tests, Shevlin must compute as-if numbers, which bias him toward finding results consistent with the off-balance sheet motivation.Shevlin also acknowledges information costs between the firm and the LP investors, similar to those identified in Wolfson (1985); however, he does not incorporate them in his tests due to lack of data.Beatty et al.(1995a) extend Shevlin to evaluate jointly tax, financial reporting considerations, and information costs.They report that firms facing high information and transaction costs will sacrifice both tax and financial reporting benefits.

The extant tax shelter studies examine syndicated individual structures that were severely limited by TRA 86.Recently a new form of corporate tax shelter has arisen.More complex than the earlier shelters, these corporate tax shelters typically involve flow-through entities, financial instruments, non-US entities, and aggressive interpretation of the tax law (Gergen and Schmitz, 1997; Bankman, 1998).Understanding corporate tax shelters and the extent to which they contribute to the recent decline in corporate tax receipts as a percentage of corporate profits are questions of policy and scholarly interest.Accountants are ideally positioned to unravel these complex transactions.Unfortunately, to our knowledge, data limitations have thwarted empirical attempts to analyze corporate tax shelters.We encourage accountants to think creatively about the data restrictions and initiate research in this area.

Although not examining tax shelters, Guenther (1992) presents further evidence on the costs of the partnership form.Guenther compares the tax and non-tax costs associated with C corporations and master limited partnerships (MLPs).While corporations face ‘‘double’’ taxation (once at the firm level and again at the shareholder level via either dividends or capital gains), partner-ships are flow-through entities facing taxation only at the partner level.

On non-tax dimensions, shareholders and limited partners (who do not materially participate in operations) enjoy limited liability; general partners do not.Before 1981 and after 1986, corporate taxation was levied on any publicly traded entity.During the interim, MLP limited partners enjoyed entity tax exemption, limited liability, and access to public capital markets.


to MLPs.Besides higher record keeping costs, partnerships face higher costs arising from indemnification insurance for managers and potentially sub-optimal investment and operating decisions.These increased costs are predicted to result in lower rates of return for businesses organized as partnerships rather than corporations.Guenther finds that MLPs report lower accounting-based measures of performance than corporations, particularly earnings before interest and taxes.

Shelley et al.(1998) discuss the tax and non-tax costs and benefits of restructuring a business as a publicly traded partnership (PTP) and examine the association between the capital market reaction to the announcement of the restructuring and proxies for the tax and non-tax factors.Among the purported benefits of a PTP formation are improved management (similar to that hypothesized with spin-offs and equity carve-outs), reduced information asymmetries about growth opportunities, and flow-through taxation.Off-setting these advantages are the problems mentioned in Wolfson (1985) and Guenther (1992).Shelley et al.(1998) find that announcement period returns are associated with proxies for these factors in the predicted direction.Finally, Omer et al.(2000) examine conversions from C corporations to S corporations in the natural resource industry following TRA 86.They discuss both the tax and non-tax costs and benefits similar to above.

This completes our review of the literature investigating the factors that impact tax management.The papers in this area consistently document that firms do not minimize taxes, rather their decisions reflect integration of multiple factors, including taxes.The interaction of financial reporting costs and taxes is well documented, however, further documentation is needed concerning the coordination of taxes and agency costs.Less is known in both areas about the relative importance of taxes.In particular, we look forward to more studies that estimate and quantify exchange rates between taxes and other considerations.

3. Taxes and asset prices

Price formation is a fundamental issue in accounting, finance, and economics.One possible price determinant is taxes.Investigations of this possibility are the second major area of current tax research in accounting.


contracting approach (‘‘all parties’’) is also important, but consideration of non-tax factors (‘‘all costs’’) is of secondary importance.

Unlike the prior section, where accountants dominate the research (particularly the coordination of taxes and financial reporting), the impact of taxes on asset prices has long been an active area of research in finance and economics.Thus, it is particularly difficult to distinguish the contributions of accounting tax researchers from those of other tax researchers.Although we continue to focus primarily on the work conducted by accounting faculty and/ or published in accounting journals (as stated in the introduction), we recognize the substantial contributions of our colleagues in finance and economics that go largely unmentioned in this review.

Our review begins with tax research in accounting that investigates the extent to which taxes affect the structure and prices of mergers and acquisitions.Next, we review early seminal papers in finance that attempted to determine the impact of taxes on the optimal capital structure followed by recent accounting research in that area.The section concludes with a discussion of the early implicit tax studies that were motivated by SW and the current interest in whether shareholder taxes affect stock prices.The common theme in these studies is the extent to which prices impound taxes.

3.1. Mergers and acquisitions

Mergers and acquisitions have been studied extensively in finance.This section reviews several tax studies by accountants that examine whether merger and acquisition structure and prices reflect corporate and investor taxes.First, however, we briefly review the relevant tax code in this complex area.

Acquisitions can be tax-free (no tax to the target firm shareholders) or taxable (gains taxable and losses deductible to the target firm shareholders).In either case, the acquirer can purchase the assets or the stock of the target.In a tax-free acquisition (asset or stock), the tax basis of the target’s assets, its tax attributes (NOL and tax credit carryforwards), and its earnings and profits (E&P), the source of dividends, are unaffected.

A taxable asset acquisition adjusts tax bases to fair market values (‘‘step-up’’) and potentially creates goodwill.11If the target is liquidated following sale of its assets, E&P are eliminated.In a taxable stock acquisition, the tax basis of the target’s assets carries over to the acquiring firm and thus no goodwill is


booked for tax purposes.However, elections permit a taxable stock acquisition to be treated for tax purposes as if it were a taxable asset acquisition.The elections are IRC Section 338 if the target is a freestanding corporation and IRC Section 338(h)(10) if the target is a subsidiary.Unlike 338(h)(10) elections, a 338 election extinguishes target E&P.

Several merger and acquisition papers address whether and to what extent the tax law governing mergers and acquisitions affects transactions.These studies address issues such as whether the benefits associated with the step-up of tax basis and deductible goodwill offset the costs of depreciation recapture and capital gains taxation of target shareholders.12 Although tax issues in an acquisition vary by the type of target (freestanding C corporation, subsidiary of a C corporation, S corporation or partnership), most extant research examines only acquisitions of freestanding C corporations.

Examining pre-TRA 86 acquisitions, Hayn (1989) finds that target and bidder announcement period abnormal returns are associated with the tax attributes of the target firm.Specifically, in tax-free acquisitions, potential tax benefits arising from net operating loss carryforwards and available tax credits positively affect the returns of bidder and target firms.In taxable acquisitions, target shareholder capital gains taxes and potential tax benefits of a step-up in basis affect the returns of both bidder and target firms involved.

Examining the structure of acquisitions over the period 1985–1988, Erickson (1998) applies an ‘‘all parties’’ approach, analyzing the role of tax and non-tax factors of the acquiring firm, the target firm and target firm shareholders.He finds that the acquirers with high marginal tax rates and an ability to issue debt are more likely to undertake a debt-financed taxable transaction.He finds little support that potential target shareholder capital gains tax liabilities or target firm tax and non-tax characteristics influence the acquisition structure.In further analysis, he finds that the magnitude of the potential target shareholder capital gains is small and that the corporate taxes immediately triggered by the step-up often exceed the present value of the tax benefits of stepped-up target assets.

Further illustrating ‘‘all parties’’, Henning et al.(2000) find that the acquirer bears target firm or shareholder taxes through higher purchase prices.This paper is not without controversy.Among other concerns, Erickson (2000) questions the validity of the sample partitions, detailing the difficulty of partitioning acquisitions as either stock or asset acquisitions and using publicly available disclosures to assess tax basis step-up.Henning et al.(2000) also


report that contingent payments to the seller (which allow deferral of taxes on some of the gain) are more likely when the seller faces a high marginal tax rate. Three papers investigate 1993 legislation that permits a deduction for goodwill amortization.Henning and Shaw (2000) find that tax deductibility resulted in an increase in purchase price of goodwill generating acquisitions, consistent with acquirers sharing the tax benefits with the selling firm, and an increase in the percentage of purchase price allocated to tax deductible goodwill.

Weaver (2000) addresses whether the frequency of taxable transactions giving rise to goodwill (e.g., tax basis step-up transactions) increased after the tax law change.She finds that the tax law change increased the probability of the taxable transaction being structured to obtain a step-up in basis and thus a deduction for goodwill.She adds that a step-up is more likely the higher the acquiring firm’s marginal tax rate.

In contrast, Ayers et al.(2000b) report that transactions with tax basis step-up remain a constant 17 percent of the taxable transactions despite the tax change.However, a significant increase in the purchase price premium following passage of the tax law change is detected for acquisitions qualifying for goodwill amortization deductions.They estimate that higher acquisition prices enable targets to obtain 75 percent of the tax benefits arising from goodwill deductibility.

To determine the role of taxes in the 338(h)(10) election, Erickson and Wang (2000) examine 200 subsidiaries that were divested in a taxable sale of stock from 1994 to 1998.As expected, they find that the election is more likely if an asset sale does not trigger too much additional tax relative to a stock sale. Consistent with the acquirer reimbursing the seller for the additional taxes, the acquisition price also is higher when the election is made.In other words, the structure of the transaction affects its price.They also report that the abnormal returns of the divesting parent are positively associated with the election’s tax benefits.

Although it is improbable that acquisitions and divestitures are initiated for tax reasons, these studies indicate the transaction structure and price are influenced by acquiring firms’ tax status, target firms’ tax status (although the evidence is somewhat mixed), and the tax attributes of the target firm.The evidence in these papers is consistent with merger and acquisition prices incorporating complex tax conditions, which are typically ignored in valuation techniques, such as revenue, earnings and/or book multiples.


is known about the extent to which non-tax costs (e.g., concerns over target liabilities, transaction costs such as transferring asset titles) interact with tax considerations.

Finally, contrary to popular belief, it is unusual for firms to trade-off tax and accounting (book) considerations when structuring mergers and acquisitions. The tax treatment and the book treatment of acquisitions differ.In particular, tax factors rarely preclude the popular pooling of accounting interests, which enables firms to avoid goodwill amortization for book purposes.Most acquisitions of freestanding C corporations involve stock purchases (and consequently carryover of inside tax basis) and can be structured to qualify for pooling treatment.The accounting treatment for asset acquisitions and acquisition of a subsidiary’s stock is independent of the tax treatment.Both result in purchase accounting.The tax and financial accounting issues in this area are complex and often misunderstood.We look forward to research that brings these two areas together.

3.2. Capital structure

3.2.1. Early finance studies

Perhaps the most developed area of tax research in finance involves capital structure choices.Capital structure has not been as dominant in tax research in accounting, but several studies have been conducted.This section reviews the development of some influential capital structure studies in finance and recent capital structure work in accounting.

Among the most influential papers in business research are Modigliani and Miller (MM, 1958, 1963), two finance papers addressing capital structure.MM (1958) show that with no taxes (and perfect and complete capital markets), the value of the firm is independent of its capital structure (and its dividend policy). MM (1963) add that if interest is deductible and dividends are not deductible, then the optimal capital structure is the corner solution of all debt.

Since MM (1963) is not clearly descriptive, finance researchers searched for non-tax costs of debt that prevented the corner solution.Some conclude that firms balance taxes against the possible bankruptcy costs associated with risky debt.Others assert that agency costs between debt and equity holders are increasing in debt (the static tradeoff theory involving taxes and agency costs). Myers and Majluf (1984) and Scott (1977), among others, report that leverage varies with the type of assets held by the firm.Ceteris paribus, firms with tangible assets can borrow more than firms with intangible assets because the property rights associated with tangible assets enable greater securitization (the debt securability hypothesis).Myers’ (1977) conclusion is the same, but he claims that growth prospects pose greater agency costs to lenders.


restrictions.In perhaps the most influential tax study of all, he predicts that investors with low marginal tax rates (e.g., exempt investors) will hold tax-disadvantaged bonds, earning taxable interest that is currently taxed.Investors with high marginal tax rates will hold stocks that do not pay dividends and derive their equity returns through favorably taxed capital gains that are deferred until sale of the stock.Miller’s insight underlies the ‘‘all taxes’’ theme in the SW framework and is fundamental to the current tax research in accounting linking equity prices and taxes.

Miller (1977) implies dividend clienteles, i.e., high-dividend stocks will be held by low marginal tax rate investors and vice versa.Many finance studies test for the existence of dividend clienteles (e.g., Miller and Scholes, 1978). One example in accounting is Dhaliwal et al.(1999).Consistent with Miller (1977), they document an increase in institutional ownership (a coarse measure for tax-exempt status) of firms that initiate dividend payments.

DeAngelo and Masulis (1980) relax Miller’s assumption that all corpora-tions face the top corporate tax rate.Recognizing interest expense is only one type of tax shield, DeAngelo and Masulis (1980) predict that leverage is less in firms with alternative tax shields, such as depreciation (debt substitution hypothesis).One test of their theory by accountants is Dhaliwal, Trezevant, and Wang (DTW, 1992) who test MacKie-Mason’s (1990) claim that the substitution effect increases as firms near the loss of tax shields (tax exhaustion hypothesis).After controlling for debt securability (which predicts a positive relation between leverage and fixed assets), DTW document a negative association between non-debt and debt tax shields, consistent with tax exhaustion.Examining 1981 legislation that caused changes in tax shields, Trezevant (1992) also finds support for debt substitution and tax exhaustion hypotheses.Together these studies document a link between taxes and capital structure that had been somewhat elusive.

3.2.2. Recent studies

Several recent studies suggest that taxes affect capital structure.Scholes et al. (1990) report that among banks, those with net operating loss carryforwards are more likely to raise capital through equity with non-deductible dividends than through capital notes with deductible interest.Collins and Shackelford (1992) link the choice between debt and preferred stock to foreign tax credit limitations.Graham (1996a), among others, adds that a firm’s marginal tax rate is positively associated with its issuance of new debt.


Myers (2000) provides further evidence that taxes matter.Introducing pension plans as a capital structure option, she reports that corporate tax benefits are increasing in the percentage of pension assets allocated to bonds, potentially resolving a longstanding puzzle in finance.Her findings confirm Black (1980) and Tepper (1981) who predict firms integrate their defined benefit plans to reduce overall taxes through arbitrage (e.g., a company issues debt, invests in stock, and deducts interest while its pension invests in bonds with tax-exempt returns).

3.3. Implicit taxes

3.3.1. Early studies

Besides motivating the recent capital structure studies in accounting, the seminal finance papers and SW are the foundation for the current tax research in accounting known as implicit tax or tax capitalization studies.This section reviews that literature, first looking at early studies, then transitioning to ongoing research in the area that investigates whether stock prices reflect potential dividend and capital gains taxes.

Miller (1977) implies that after-tax rates of return are identical across all assets, conditional on risk and assuming no market frictions or government restrictions.SW (1992, Chapter 5) define implicit taxes as the reduced rates of returns for tax-favored investments required for this equality to hold.The classic example of implicit taxes is the lower pretax returns on municipal bonds.Because the interest earned on municipal bonds is tax-exempt, taxable investors are willing to pay more for municipal bonds than equally risky alternative investments, such as corporate bonds.Investors in the highest tax brackets will value the exclusion on municipal bond interest the most and thus a clientele of high-tax investors will hold municipal bonds.

An initial implicit tax study in accounting is Shackelford’s (1991) examination of the interest rates of leveraged employee stock ownership plans (ESOP).The Tax Reform Act of 1984 excludes half the interest income on ESOP loans from income taxation.Because the benefits of interest exclusion are uncertain, most ESOP loans provide a form of tax indemnification. Specifically, two interest rates are provided in an ESOP loan agreement.The first assumes that the exclusion is available to the lender.The second assumes that the loan’s interest income is fully taxable.


borrower as lower interest rates.This finding is analogous to findings in Ayers et al.(2000b) and Henning and Shaw (2000) that target shareholders extract part of the benefits of goodwill deductibility from acquirers through higher acquisition prices.

Differentially taxed investments attract different clienteles.Consistent with this prediction, Shackelford finds that high tax rate lenders dominate the ESOP loan market.He concludes that ESOP interest rates reflect the tax treatment accorded their lenders and that the lenders are the financial capital suppliers who can most benefit from the favorable tax treatment.

Other early implicit tax studies include Stickney et al.(1983), Berger (1993), and Guenther (1994b).Stickney et al.(1983) estimate that in 1981 General Electric Credit Corporation paid roughly 70 cents on the dollar for tax benefits related to safe harbor leasing.Berger adds that the tax benefits accorded research and development affect its asset price.Guenther detects a small response in the interest rates of Treasury securities to changes in the taxation of individuals.

More recently, Erickson and Wang (1999) document that by redeeming Seagram’s shares at a below-market rate in 1995, DuPont retained 40 percent of Seagram’s tax savings.On the other hand, Engel et al.(1999) show that taxes had little effect on asset prices in their TRUPS study.

3.3.2. Marginal investor

Shackelford’s (1991) results imply that the marginal provider of ESOP capital has a marginal tax rate that approaches the statutory tax rate.As a result, ESOP interest rates clear at a level that reflects the relatively high tax rate of the marginal investor.In other words, the research question could be restated as, ‘‘Who is the marginal investor?’’

If Shackelford had found no difference between ESOP interest rates, he could not have rejected the implicit tax concept.Instead the evidence would have been consistent with (a) the marginal provider of ESOP capital being a tax-exempt organization, facing a zero marginal tax, or (b) market frictions or government restrictions impeding price adjustments.Because neither frictions nor restrictions seem likely in Shackelford’s (1991) setting, his paper can be recast as an estimation of the marginal tax rate of the marginal investor.In this light, the differences in ESOP interest rates can be interpreted as providing evidence that the marginal lender is in a high-tax bracket.